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Portugal’s supplementary pension funds have increased their equity weightings but are still cautious on fixed-income, writes Gail Moss

Portugal’s financial sector has experienced a roller-coaster ride over the past summer.

In May, the country came out of its three-year-long €78bn bailout, while the Organisation for Economic Co-operation and Development (OECD) forecast an economic recovery faster than expected, as well as falling unemployment, based on fiscal consolidation and structural reforms.

But then August brought the shock of a government bailout for Banco Espirito Santo, on the brink of collapse because of heavy losses incurred largely through fraudulent loans made between some group companies.

However, in the 12 months preceding the bailout, occupational pension funds had made few changes in asset allocation, and it seems unlikely this will change.

Debt securities remain the main asset class in pension fund portfolios, accounting for more than 49% of the total as at end-March 2014, including both directly-held debt and bond funds. Meanwhile, equities accounted for 21%, according to the Portuguese Association of Investment Funds, Pension Funds and Asset Management (APFIPP).

Over the past few months, allocations for both directly-held public debt and equity have risen by a couple of percentage points, the former from 24.3% to 26.1% of portfolios as at end-March 2014. Real estate allocations have fallen by a similar percentage.

José Veiga Sarmento, president of APFIPP, says: “These figures reveal that pension fund managers are optimistic that the crisis in the public debt of European countries is already over, and they are also confident about the economic outlook that favours investment in shares.”

He adds: “The increase in public debt is probably a sign that pension fund managers are more confident in relation to the weaker euro-zone countries, especially those that were bailed out. So we believe at least part of the increase in public debt investment was directed to those countries.”

His views are borne out by José Luís Borges, head of institutional client portfolios, BPI Gestão De Activos (BPIGA), whose company has increased its exposure to domestic fixed income over the past 12 months, although it is still underweight in fixed-income generally.

The increase is mainly in government debt, with some corporate bonds bought on a “highly selective” basis. “Portugal has had a debt crisis for some years, but the risk now seems much better than two or three years ago,” Borges says. “And although the appreciation potential in Portuguese bonds is also smaller, we think it’s appropriate to invest, as there is less risk.”

Most of BPIGA fixed-income exposure is in the euro-zone, and Portugal, Spain and Italy make up half of this. “Those three countries are giving better yields than other countries,” says Borges. “Short-term yields for core countries are almost zero, and even 10-year yields are only 1 or 2%. But we have a good premium on the periphery, although it has gone down since the start of 2014 and spread compression has been substantial since the beginning of the year.”

Meanwhile, BPIGA has also lowered the maturity of its bonds. “Large fixed-income benchmark allocations are a challenge for the managers due in our view to the asymmetric return potential in bonds originating from all-time lows in yields to maturity,” Borges notes. “So we prefer to have less exposure to interest rates. Then, if rates go up, we suffer less.”

If interest rates rise significantly, BPIGA will probably lengthen the maturities of its debt, but that is not expected within the next 12 months.

Others in the pensions industry are more cautious. Rui Guerra, partner, head of Mercer Portugal Investments, says: “Some pension funds have increased the exposure to Portuguese, Spanish and Italian bonds but it was not a significant move. Most exposure is to more core countries.”

He adds that while the overhang of the financial crisis has not significantly affected asset allocation, since many pension funds are matching their liabilities one way or another, diversification has increased.

The Portuguese pension industry has had its fair share of troubles over the past 12 months. The near collapse of banking giant Banco Espírito Santo (BES) put the country’s wider financial system under serious pressure.

After BES declared devastating losses earlier this year, the Portuguese government was forced to inject €4.9bn and split the institution in August. The ‘bad bank’ took over riskier assets and the bank’s ‘healthy’ assets, including those managed on behalf of pension funds, were transferred to a ‘good bank’ named Novo Banco.

Portugal’s central bank, Banco de Portugal (BDP), recently stated that BES’s assets and liabilities had been integrated in Novo Banco with no impact on customers or suppliers.

According to Portugal’s investment and pension fund association APFIPP, as of the end of March this year, ESAF managed €1.8bn worth of assets on behalf of Portuguese pension schemes – a share of 11.9% of the private pension fund market.

José Veiga Sarmento, chairman of APFIPP, says: “The restructuring of BES has no impact at all on the pension industry. Pension fund assets invested in BES securities are negligible. There has been no shockwave on pension funds. These assets are protected by law, and the pension fund manager owned by the group continues to this day under the new bank.”

Still, pension funds and their managers were left with a reputational damage that has to be repaired, believes Nuno Abreu, executive director of Aon Hewitt in Portugal. “Although regulation is transparent, stating clearly that assets belong to members, it is difficult to explain to employees and employers that their assets are safe. There are worries that what happened to BES could happen to other institutions. We are carrying our communication work to clarify this issue.”

Abreu also suggests that, as a result of the BES debacle, asset management professionals may see their employment situation in a different light. “Worries that other institutions could share the same destiny at BES may lead professionals to spend time thinking about their career prospects. This could potentially have an impact on investment performance.”

Despite official statements saying that the issue is resolved, doubts remain about the possible consequences. A source close to the matter admits the “the future structure of the [Banco Espírito Santo] Group companies is not yet known.”

Meanwhile, over the past year, F&C Portugal has been blending the actively invested core of its client portfolios with some passive strategies in both equities and fixed income.

Passive strategies in fixed-income have focused on specific credit ratings and maturities.

“In both equities and fixed-income we have been overweight in peripherals,” says Joao Pedro Palmela, head of institutional client services, F&C Portugal. “For fixed-income, our preference is for Spain and Italy. With most clients we are restricted from acquiring below investment grade, so we are out of Portugal. We are also overweight credit exposure in the search for yield.”

In terms of maturities, the manager has also been moving from neutral to underweight duration. Palmela says: “We have been using derivatives to shorten duration. The overall underweight duration is a blend of being overweight duration on the peripherals and underweight duration on the core.”

F&C Portugal has also been adding corporate credit to portfolios. While not as attractive as equities in recent months, this helps avoid low-yield issues, says Palmela.

In terms of returns from the manager’s portfolios, however, fixed-income trails equities.

For F&C Portugal’s most cautious portfolio (100% fixed-income), net returns for the 12 months to 30 July 2014 were 4.1%.

For the medium-risk portfolio (up to 25% equities), the net return for the same period was 7.24%, while for the higher-risk portfolio (up to 40% equities), net return was 8.89%.

On the whole, however, the effects of the financial crisis are still being felt in equity allocations. At end-June 2007, directly-held equities made up 28.3% of pension fund portfolios, according to APFIPP; the current level of 11.1% represents a fall of 60% since then, despite a recovery in recent months.

And while alternatives make up a negligible percentage of pension fund portfolios, some managers are still bold enough to increase their exposure.

Since the last quarter of 2013, F&C Portugal has been making off-benchmark bets versus the European market, starting with Japan, then moving, in turn, to the UK and US. Most of the equity segments of portfolios are now being run on this basis. “We used passive vehicles because we think those markets will go up on a relative basis,” says Palmela. “On the whole, it has worked – in particular, we were able to capture the market performance in Japan last year, and more recently the US. We will probably carry on with it as a global tactical asset allocation investment process, as we still see better prospects in other markets than in Europe.”

But Veiga Sarmento says pension funds are cautious about investing in alternatives, other than in real estate, which accounts for significant allocations. “Investment in alternatives is limited by law,” he notes. “Non-listed securities are limited to 15% of the portfolio, while investment in non-UCITS funds is limited to 10% This means that investment in alternatives is not significant.”

But some managers are comfortable with the alternatives asset class. BPIGA had virtually no alternative investments until the past year, and in the beginning of 2014 it invested in long-short equity market neutral funds.

Borges says: “We chose this asset class because of our expertise in this area in terms of the products, and manager selection. We expect to make positive returns, with some risk of course. But this asset class historically has a good relationship between risk and returns.”

In fact, the asset class was also chosen in order to diversify exposure away from fixed income, which in most of BPIGA’s client portfolios has a greater allocation than equities.

“Most of our expected return comes from equities,” says Borges. “We are overweight there, but don’t want to be aggressively so, so we invested in alternative funds because the risk is much lower than for pure directional equities.”

Up to 5% of clients’ portfolios, including discretionary mandates and open-ended funds, have been invested this way, using UCITS structures rather than hedge funds; Borges says these offer more disclosure and regulation than hedge funds, and therefore more control.

Turning to the next 12 months, Veiga Sarmento says: “Considering that interest rates are at historical lows and that the economic outlook presents good perspectives, we believe that there is room for greater investment in equities at the cost of less investment in debt securities.”

He adds: “The Portuguese real estate market is starting to show signs of recovery, and it’s possible we may also see a small increase in the investment in these types of assets.”

Guerra concludes: “In the next 12 months, we expect to see an increase in alternatives. We also expect to continue to see more diversification, such as high yield and emerging markets.”

Portugal desperately needs to push growth in second-pillar saving. But over recent years the government has had to prioritise a first pillar reform as part of its now concluded €78bn bailout programme sponsored by the IMF and the EU.

To comply with the terms of the agreement, the government has significantly reduced state pensions. At one point this punishing new regulation also threatened to cut second-pillar retirement benefits.

The budget law approved at the end of 2013 introduced a levy on pensions, the ‘extraordinary solidarity contributions’ (or CES, Contribuição Extraordinária de Solidariedade). Because of the wording of the decree, initially it appeared that it would be applied to both state benefits and second-pillar pensions.

José Veiga Sarmento, chairman of the Portuguese investment and pension fund association APFIPP, says the levy will be scrapped in 2015 and pensioners’ private pension income will be intact. However, there is little confidence about the government’s intentions to stimulate second-pillar savings.

Like in many other countries, Portuguese employees tend to have a distorted perception of their retirement prospects. Marta Frazao, head of retirement benefits at Mercer Portugal, believes there is a danger that most employees will decide to continue working when they reach normal retirement age of 66 years. Because of the lack of awareness and insufficient accrued pension benefits, they might choose to work until the mandatory retirement age of 70 years and this could affect the country’s labour market, Frazao says.

Experts agree that, at this stage, the supply-side reforms that have been approved or are being discussed in Portugal do not include incentives to subscribe to or create pension plans. Sarmento believes Portuguese lawmakers should investigate the introduction of automatic enrolment in Portugal. “We ask that the government introduces different ways to stimulate second-pillar savings, such as automatic enrolment. It has been a success in the UK and it would be a most adequate response to the problem in Portugal.”

Despite the lack of incentives, a more positive economic outlook for the country is leading larger employers to focus more on retirement benefits. Simultaneously, international asset managers are expanding their presence in the country.

“Over the past years, offering a pension plan as part of benefit packages in Portugal was not among the priorities for multinationals. Now we are getting a green light to start building pension plans”, say Abreu.

Frazao says that, from the employers’ perspective, current regulation makes offering benefits more tax efficient than increasing salaries, and that companies are realising this opportunity. “The number of companies that are redesigning their benefit structures is growing very fast”, she says.

Additionally, Abreu explains that pension funds are turning to international asset managers. “This trend is accelerating. Because of current regulation, Portuguese managers are still involved with most pension plans, but companies are looking to sign global agreements. In some cases, Portuguese fund managers are used only for administration purposes and international managers are actually responsible for the assets. It is a comfort for employees to know that their money is managed by the best or the largest managers globally. This also has positive effects for the Portuguese financial industry.”